Footnotes · EA Part 2 study notes · Partnerships · Operations and Taxable Income
Operations and Taxable Income
At the desk
| Basis order | + income (incl. tax-exempt) and debt increases; – distributions; – nondeductibles; – losses last, not below zero |
| Liabilities | Recourse by economic risk of loss (guarantor takes it all); nonrecourse by profit share; LLC bank debt with no guarantee is nonrecourse |
| Separately stated | Capital and 1231 gains, GPs, interest/dividends/royalties, rentals, charitable, foreign tax, 179, distributions, QBI items. 4797 Part II is ordinary |
| Loss gates | Basis (704(d)) → at-risk (465, Form 6198) → passive (469, 8582) → excess business loss (461(l), Form 461: $256,000 / $512,000 for 2026) |
| 163(j) | 30% of EBITDA-based ATI, permanent; small-business exemption at $31M average receipts (2025); excess interest reduces partner basis |
| Trap | Deducting a loss off the K-1 capital account without checking basis; counting a nonrecourse share as at-risk |
On this page
- Partnership-Incurred Liabilities 1 note
- Recourse Liabilities 7 notes · 1 example
- Nonrecourse Liabilities 3 notes · 2 examples
- Partnership Cancellation of Debt 1 note
- Partners' Capital Accounts 4 notes · 1 example
- Partner's Taxable Income 5 notes
- Partnership Taxable Income 3 notes
- Separately Stated Items 18 notes
- Ordinary Income 4 notes · 1 example
- Deductions 3 notes
- Contributions to Employee Retirement Accounts 3 notes
- Partner's Distributive Share 5 notes
- Precontribution Gain or Loss 8 notes · 1 example
- Character 4 notes
- Elections by Partnership or Partner 14 notes
- Adjustments to Basis 8 notes · 1 example
- Loss Limits 1 note
- Basis Limit 1 note · 1 example
- At-Risk Rules 6 notes
- Excess Business Loss 3 notes
- Gift of a Partnership Interest 4 notes
- Inheritance 4 notes
A partnership is a business organization other than a corporation, a trust, or an estate, co-owned by two or more persons and operated for a profit. The partnership, as an untaxed, flow-through entity, reports taxable income or loss and separately stated items.
- When computing his or her personal income tax liability, an individual partner must consider his or her distributive share of the partnership's taxable income or loss and every other separately stated item for the partnership, regardless of whether any distributions were made from the partnership to the partner.
- Nonseparately and separately stated partnership items are currently taxed to the partners, but distributions are generally received tax-free.
- The things to watch, from my notes:
- Partnership inventory and unrealized receivables are very important because they can trigger ordinary income to one partner when another partner receives a distribution (even of money).
- Pre-contribution gain must be identified as it can trigger and recharacterize otherwise unrecognized capital gain.
- Partnership liability fluctuations vary the partners' bases in their partnership interests and affect treatment of distributions.
- Be prepared to identify a payment to a partner as a guaranteed payment, as a distributive share, or in a nonpartner capacity, and the effect of the classification, e.g., a deduction to the partnership passed through ratably to all partners.
Partnership-Incurred Liabilities
- A partner's share of partnership liabilities affects the partner's basis in his or her partnership interest and can result in increased gain being recognized by the partner. Any increase in a partner's share of liabilities increases the partner's basis. The opposite is true for a decrease in partnership liabilities.
Recourse Liabilities
- A liability is a recourse liability if the creditor has a claim against the partnership or any partner for payment if the partnership defaults.
Example — Recourse Liability
ABC Partnership, a general partnership, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank secured by the building. Later, the building is destroyed and becomes worthless. Because ABC is a general partnership, ABC's general partners are liable for the debts of the partnership in the event the partnership is unable to pay. If ABC defaults on the mortgage, XYZ can take legal action against the partners of ABC to pay the $90,000 debt. Thus, the loan is recourse to the partners of ABC (i.e., the partners bear the economic risk).
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- Partners generally share recourse liabilities based on their ratio for sharing losses.
- However, regulations allocate a recourse liability to the partner(s) who would be liable for it if, at the time, all partnership debts were due, all partnership assets (including cash) had zero value, and a hypothetical liquidation occurred.
- A partner who personally guarantees a partnership loan bears the economic risk of loss for the whole guaranteed amount and takes all of it into basis; the other partners take none.
- A side agreement capping a partner's liability caps the partner's share: a general partner liable for all debts but limited by agreement to $10,000 includes $10,000.
- A limited partner cannot share in recourse debt in excess of any of his or her obligations to make additional contributions to the partnership and any additional amount(s) that (s)he would actually lose if the partnership could not pay its debt. added 2026 The same is true of an LLC member who has not guaranteed the debt: an LLC's bank loan is nonrecourse to its members for Sec. 752 purposes.
- Partners generally share recourse liabilities based on their ratio for sharing losses.
Nonrecourse Liabilities
- The creditor has no claim against the partnership or any partners. At most, the creditor has a claim against a particular secured item of partnership property.
- Generally, partners share in nonrecourse liabilities based on their ratio for sharing profits (after minimum gain and Sec. 704(c) minimum gain, which are usually zero in a small partnership).
- Nonrecourse debt gives basis but not at-risk amount, except qualified nonrecourse financing on real property.
Example — Nonrecourse Liabilities
ABC, LLP, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank. The loan was secured by the building itself and no partner made a personal guarantee on the loan. In the event that ABC defaults and is unable to pay the loan, XYZ's only option is to foreclose and sell the property. If the property's value has decreased and the sale proceeds are insufficient to recover the balance of the loan, XYZ has no other legal remedy. This is because ABC's partners have limited liability by being partners in an LLP and are not generally liable for the debts of the partnership. Thus, the loan is nonrecourse to the partners of ABC (i.e., the lender bears the economic risk, not the partners).
Example — Recourse vs. Nonrecourse and Basis
Juan and Teresa form a cash-basis general partnership with $20,000 each and share equally. The partnership borrows $60,000 to buy equipment. If neither partner bears the economic risk, the debt is nonrecourse and each partner's basis is $50,000. If Teresa alone must pay the creditor on default, her basis is $80,000 and Juan's is $20,000.
Partnership Cancellation of Debt
- In general, if the taxpayer has cancellation of debt income because debt is canceled, forgiven, or discharged for less than the amount the taxpayer must pay, the amount of the canceled debt is taxable and the taxpayer must report the canceled debt on the tax return for the year the cancellation occurs. COD income is separately stated; the insolvency and bankruptcy exclusions are tested at the partner level, and the decrease in the partner's debt share is a deemed distribution in the same year.
Partners' Capital Accounts
- A capital account is maintained for each partner at the partnership level.
- A partner's initial capital account balance is the fair market value (FMV) of the assets (net of liabilities) (s)he contributed to the partnership (the book capital account). added 2026 The K-1 item L capital account has been required on the tax-basis method since 2020: it starts from the adjusted basis of contributed property, not FMV, and it excludes the partner's share of liabilities and any Sec. 743(b) adjustment.
- It is separate from the partner's adjusted basis (AB) in his or her partnership interest.
- The basis in partnership interest is assessed in order to track the tax position of the investment.
Example — Adjusted Basis of Contributed Property
Taxpayer contributes property that has an adjusted basis of $400 and a fair market value of $1,000. Taxpayer's partner contributes $1,000 cash. While each has increased their book capital account by $1,000, the adjusted basis of Taxpayer's partnership interest is only $400 and the adjusted basis of Taxpayer's partner's partnership interest is $1,000.
Partner's Taxable Income
- A partner's taxable income may be affected by his or her interest in a partnership in several ways. Examples include
- His or her distributive share of partnership income and separately stated items
- Sale of his or her partnership interest
- Dealings with the partnership (e.g., guaranteed payments)
- A partner reports his or her distributive share of partnership items for the partnership's tax year that ends with or within the partner's tax year.
Partnership Taxable Income
- Partnership taxable income is determined in the same way as for individuals except that certain deductions are not allowed for a partnership, other items are required to be separately stated, and business interest expense is limited.
- added 2026 Business interest (Sec. 163(j)) is limited at the partnership level to 30% of adjusted taxable income; the 2025 act permanently restored the EBITDA-based computation (ATI without depreciation, amortization or depletion) for tax years beginning after 2024. Excess business interest passes to the partners and reduces their basis in the year allocated. Small partnerships (average gross receipts of $31 million or less for 2025) are exempt unless they are tax shelters.
- added 2026 Domestic research costs are deductible again under Sec. 174A for tax years beginning after 2024; 100% bonus depreciation is permanent for property acquired after January 19, 2025. Both flow through on the K-1.
Separately Stated Items
- Each partnership item of income, gain, deduction, loss, or credit that may vary the tax liability of any partner must be separately stated. Items that must be separately stated include the following:
- Section 1231 gains and losses
- Net short- and long-term capital gain or loss from the sale or exchange of capital assets
- Guaranteed payments
- Interest and dividend income
- Royalties
- Tax-exempt income and related expenses
- Investment income and related expenses
- Rental activities, portfolio income, and related expenses
- Cancellation of debt
- Recovery items (e.g., prior taxes, bad debts)
- Charitable contributions
- Foreign income taxes paid or accrued
- Depletion on oil and gas wells
- Section 179 deductions
- Distributions
- Qualified items of income, gain, and loss for the qualified business income deduction
- Ordinary gains and losses from Form 4797 Part II are not separately stated; they are part of ordinary income.
Ordinary Income
- This is all taxable items of income, gain, loss, or deduction that are not separately stated.
- Ordinary income is different from taxable income, which is the sum of all taxable items, including the separately stated items and the partnership ordinary income or loss.
- Ordinary income includes such items as gross profit, administrative expenses, and employee salaries.
- Exception: Guaranteed payments are subtracted as expenses for computing ordinary business income but are separately stated as income to the recipient partner.
- Ordinary income is different from taxable income, which is the sum of all taxable items, including the separately stated items and the partnership ordinary income or loss.
Example — Ordinary Income vs. Separately Stated
Comfy Chairs had chair sales of $75,000, cost of goods sold $10,000, employee wages $15,000, rental real estate income $20,000 and charitable contributions $500. Ordinary business income on Schedule K is $50,000 ($75,000 – $10,000 – $15,000). The rental income and the contributions are separately stated.
Deductions
- Certain deductions, e.g., charitable contributions, are disallowed in computing partnership taxable income. These are items that must be separately stated by the partnership.
- Each partner may be entitled to a deduction for his or her distributive share of these items in computing his or her personal tax liability.
- The Sec. 179 dollar limit and the taxable-income limit apply at both the partnership level and the partner level. A $30,000 purchase by a partnership with $25,000 of taxable income passes through $25,000 of 179, split between the partners.
Contributions to Employee Retirement Accounts
- Contributions made by a partnership for its employees under a qualified SEP, SIMPLE IRA, pension, profit sharing plan, annuity plan, or another deferred compensation plan may be deducted subject to limitations.
- Contributions to an employee's IRA are included in the employee's salaries and wages.
- Contributions for the partners themselves are separately stated and deducted on the partners' own returns.
Partner's Distributive Share
- Each partner is taxed on his or her share of partnership income whether or not it is distributed.
- A partner's distributive share of any partnership item is allocated by the partnership agreement as long as the allocation has substantial economic effect, which means the allocation is not for tax avoidance.
- For example, allocation of tax-exempt income to one partner and taxable interest (equal in amount) to another partner in a lower tax bracket has no substantial economic effect; i.e., it is motivated by tax avoidance.
- If the partnership agreement does not allocate a partnership item, the item must be allocated to partners according to their interests in the partnership.
- A tiered allocation (20% of the first $1 million to the general partner, 25% of the next, then the balance by percentage) is honored if it has economic effect; compute the preferred layer first and share the remainder.
- A partner's distributive share of any partnership item is allocated by the partnership agreement as long as the allocation has substantial economic effect, which means the allocation is not for tax avoidance.
Precontribution Gain or Loss
- To the extent of gain not recognized on contribution of property to the partnership, gain or loss subsequently recognized on the sale or exchange of an asset by the partnership must be allocated to the contributing partner (Sec. 704(c)).
- Postcontribution gain or loss is allocated among partners as distributive shares, i.e., as any other gain or loss.
Example — Postcontribution Gain or Loss
Tony and Mary form a partnership as equal partners. Tony contributes cash of $100,000, and Mary contributes an asset with a basis of $80,000 and a FMV of $100,000. Two years later, the partnership sells the asset for $110,000. The $30,000 gain ($110,000 selling price – $80,000 basis) is allocated, $25,000 to Mary [$20,000 precontribution gain + (50% partnership interest × $10,000 postcontribution gain)] and $5,000 to Tony (50% partnership interest × $10,000 postcontribution gain).
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- A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution (Sec. 737).
- The gain recognized is the lesser of the following amounts:
- The excess of the fair market value of the property received in the distribution over the adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution.
- The "net precontribution gain" of the partner. This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution and held by the partnership immediately before the distribution were distributed to another partner other than a partner who owns more than 50% of the partnership.
- The character of the gain is determined by reference to the character of the net precontribution gain. This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership.
- The gain recognized is the lesser of the following amounts:
- A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution (Sec. 737).
Character
- The character of distributive shares of partnership items is generally determined at the partnership level.
- Any capital loss (FMV < AB) inherent at contribution is capital loss to the extent of any loss realized when the partnership disposes of the property. This applies for 5 years after contribution.
- Partnership gain or loss on contributed inventory and unrealized receivables is ordinary income. This treatment of the inventory (but not the receivables) disappears 5 years after contribution.
- If the size of a partner's interest in the partnership varies (e.g., by sale, purchase, exchange, liquidation) during a partnership tax year, the distributive shares of partnership items must be apportioned on a daily basis (or by closing the books, if the partners agree).
Elections by Partnership or Partner
- A few of the elections available to partnerships are made at the partnership level:
- Partnerships make all elections available (except for those listed below), such as
- Methods of accounting
- Computing depreciation (including bonus and electing out of it, and Sec. 179)
- Inventory methods
- Installment method election
- Expensing intangible drilling and development costs
- The Sec. 754 election
- These elections apply equally amongst all partners; however, no election made by a partnership has any force or effect with respect to any partner's nonpartnership interests.
- Partners make the following elections on the individual income tax return:
- Deduction or credit of foreign income taxes paid
- The amount is limited to the partner's distributive share from the partnership.
- Treatment of mining and exploration expenditures
- Basis reduction following discharge of indebtedness (Sec. 108 exclusions are applied at the partner level)
- Deduction or credit of foreign income taxes paid
- Partnerships make all elections available (except for those listed below), such as
Adjustments to Basis
- The basis of a partner's interest in a partnership is adjusted each year for subsequent contributions of capital, partnership taxable income (loss), separately stated items, variations in the partner's share of partnership liabilities, and distributions from the partnership to the partner.
| Item | |
|---|---|
| Initial basis | |
| + | Subsequent contributions of capital |
| +/– | Distributive share of partnership ordinary business income (loss) |
| + | Separately stated taxable and nontaxable income |
| – | Separately stated deductible and nondeductible expenditures |
| + | Increase in allocable share of partnership liabilities |
| – | Decrease in allocable share of partnership liabilities |
| – | Current-year excess business interest expense |
| – | Share of the adjusted basis of charitable property contributions and foreign taxes paid or accrued |
| – | Distributions from partnership |
| = | Adjusted basis in partnership interest |
Example — Year-End Adjusted Basis
The taxpayer's ownership and basis in the partnership are 50% and $15,000, respectively, at the beginning of the year. The partnership has ordinary income of $8,000, made charitable contributions of $3,000, and made a $5,000 distribution to the taxpayer. The taxpayer's basis at the end of the year is $12,500 [$15,000 beginning basis + ($8,000 ordinary income × 50% ownership) – ($3,000 charitable contribution × 50% ownership) – $5,000 distribution].
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- Basis is adjusted for variations in a partner's allocable share of partnership liabilities during the year, e.g., by payments on principal. A $200,000 loan taken to pay off a $170,000 loan nets to a $30,000 increase in the partners' debt share.
- Partner capital accounts are not adjusted for partnership liability variations.
- Basis is not reduced below zero.
- The order matters: increase for income first; then reduce for distributions; then nondeductible expenses; then losses, which are the item that gets suspended. A $5,000 meals charge that is 50% nondeductible reduces basis by the full $5,000.
- Basis is reduced without regard to losses suspended under passive activity loss rules and at-risk rules or losses creating an NOL under the excess loss rules.
- No adjustment to basis is made for guaranteed payments received.
- Basis is adjusted for variations in a partner's allocable share of partnership liabilities during the year, e.g., by payments on principal. A $200,000 loan taken to pay off a $170,000 loan nets to a $30,000 increase in the partners' debt share.
Loss Limits
- A partnership ordinary loss is a negative balance of taxable income. A partner's loss passes four gates in order: basis, at-risk, passive, excess business loss.
Basis Limit
- A partner's distributive share of a partnership ordinary loss is allowable as a deduction to the partner only to the extent of the partner's AB in his or her interest in the partnership at the end of the year. Excess loss is deductible in a subsequent year in which AB is greater than zero.
Example — Basis Limit with Recourse Debt
Jane has a 30% interest in a cash-basis general partnership and a $50,000 basis at the start of the year. The partnership borrows $200,000 (all partners personally liable) and uses $170,000 of it to pay off an existing note. Her basis: $50,000 + $60,000 – $51,000 = $59,000. Her share of the $250,000 loss is $75,000, but she deducts $59,000; $16,000 waits for basis.
At-Risk Rules
- Each partner may deduct only a partnership ordinary loss to the extent (s)he is at risk with respect to the partnership.
- The at-risk limits also apply at the partnership level with respect to each partnership activity.
- The amount of a partnership loss currently deductible (up to an amount for which the partnership bears economic risk of loss with respect to each partnership activity) is allocated to partners as a deductible distributive share.
- Only partnership liabilities for which a partner is personally liable can be considered in a partner's at-risk limit; a share of a nonrecourse liability is not at risk, except qualified nonrecourse real estate financing.
- Passive activity losses are deductible in the current tax year only to the extent of gains from passive activities (in the aggregate).
- Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity.
Excess Business Loss
- When total losses from all trades or businesses exceed all gross income and gains from all sources, only $256,000 of the net loss is deductible on an individual return ($512,000 in the case of MFJ) for 2026; the 2025 figures were $313,000 and $626,000. updated 2026
- Any nondeductible loss is treated as a net operating loss carryover to the following year.
- added 2026 The limitation was made permanent by the 2025 act; it applies at the partner level, after basis, at-risk and passive. Form 461.
Gift of a Partnership Interest
- Generally, no gain is recognized upon the gift. However, if partnership liabilities allocable to the gifted interest exceed the AB of the partnership interest, the donor must recognize gain. No loss is recognized on the gift.
- The donee's basis in the interest is the donor's basis after adjustment for the donor's distributive share of partnership items up to the date of the gift.
- For purposes of computing a loss on a subsequent sale of the interest by the donee, the FMV of the interest immediately prior to the gift is used if the FMV of the gifted partnership interest is lower than the basis at the time of the gift.
- In a family partnership where capital is a material income-producing factor, the donor must first be allocated reasonable compensation for services before the donee's share is figured.
Inheritance
- The tax year of a partnership closes with respect to a partner whose entire interest in the partnership terminates, whether by death, liquidation, or otherwise.
- The successor has a FMV basis in the interest (less IRD).
- The partnership tax year does not close with respect to the other partners.
- The deceased partner's share of self-employment income runs through the end of the month of death: a partner who dies August 20 with an $18,000 share for the year has $12,000 (8/12) of SE income.
Private reference, not client advice. Original notes written 2022–2023 while studying for the SEE Part 2; figures updated October 2026 (Rev. Proc. 2025-32, Rev. Proc. 2026-15, P.L. 119-21). Verify current-year amounts before relying on them.